Investors are broadly saving on fund fees versus 10 years ago, but there are still plenty of ways for them to lose money in risky or gimmicky vehicles, says Morningstar FundInvestor editor Russ Kinnel.

The Proof Is in the Pudding

Last week we wrote about the Parent pillar of the Morningstar Analyst Rating. As we pointed out, the fund companies that receive Positive Parent scores have a few traits in common. Those firms' funds frequently feature lower fees, longer-tenured managers, and managers who invest their own money alongside fund shareholders. However, we don't expect investors to simply take our word for it that these practices are important. Instead, in this article we offer data and studies to demonstrate that Parent ratings, and the metrics we use to assign them, have very real implications for investor experience.

The Price Is RightOne of the most straightforward measurements of shareholder-friendliness is mutual fund expenses. Lower fees generally increase investors' chances of success, and firms will often take steps to reduce expenses, such as instituting fee breakpoints or lowering overall expenses as a fund grows. Of all the firms that currently receive Parent ratings from Morningstar, those with a Positive rating have a Firm Average Fee Level of 49, suggesting that their funds are generally in line with their peer groups. Firms that receive Neutral or Negative ratings weigh in at Firm Average Fee Levels of 53 and 65, respectively, suggesting a slightly more expensive menu of investment options.

- source: Morningstar Direct as of 8/31/2012

Some firms argue that higher expenses are justified because the managers add enough value to make up the cost. Unfortunately, the data suggests otherwise. My colleague Russ Kinnel conducted a study in 2011 that showed that lower-cost funds consistently outlive and outperform higher-cost funds. For some asset classes the difference is eye-opening. According to his study, cheap municipal-bond funds survived and outperformed more than 6 times as frequently as the most expensive municipal-bond funds.

His conclusions hold true at the firm level as well. When looking at all U.S. open-end mutual fund companies with assets greater than $1 billion, the firms with an average Fee Level of Low or Below Average (that is, 1st to 40th percentile) had, on average, 54% of their funds both survive and outperform their category average in the five-year period. In contrast, firms with an average Fee Level of Above Average or High (that is, 61st to 100th percentile) could only say the same for 42% of their funds.

- source: Morningstar Direct as of 8/31/2012

There's No Substitute for ExperienceMorningstar analysts frequently point to long-tenured management teams as a desirable quality in a fund. As such, Positive-rated parent companies tend to have longer average firm tenure than Negative- or Neutral-rated firms, as shown below.

- source: Morningstar Direct as of 8/31/2012

The logic behind preference for longer tenure is intuitive. Managers who have run a fund for many years have more practice at implementing and perfecting the strategy, and investors have more time to evaluate the manager's performance in different market environments. On this point the data conforms to intuition. When looking at all U.S. fund companies with assets greater than $1 billion, funds offered by firms with average manager tenure of more than 10 years fared considerably better than those offered by firms with average manager tenure of five years or less. The firms with longer tenure can boast that 50% of their funds both survived and outperformed in the past five years compared with 36% for the firms with the shortest tenure.

- source: Morningstar Direct as of 8/31/2012

It's important to note that tenure is not the same as manager retention, another data point we consider in assigning our Parent pillar ratings. Tenure measures manager turnover on the fund level, while retention measures manager turnover at the firm level. Just like with tenure, Positive-rated firms tend to have higher manager retention than Neutral- or Negative-rated firms. On average, Positive-rated Parents have kept 95% of their investment staff each year over the past five years, compared with 89% to Negative-rated Parents.

- source: Morningstar Direct as of 8/31/2012

And as with tenure, the data suggests that firms with a better record of retaining their investment staff also have a better record of their funds both surviving and outperforming. Here, it seems that while high manager retention doesn't guarantee outperformance, low manager retention is a strong indicator of underperformance, mergers, and liquidations. On average, firms that have a five-year manager-retention rate below 85% have a whopping two thirds of their funds underperform, merge, or liquidate in the five-year period.

- source: Morningstar Direct as of 8/31/2012

Pick Managers Who Walk the LineIn 2011, my colleague David Kathman wrote an article showing that funds with high manager ownership outperformed funds with low ownership. He reasons that managers who invest in their funds have more conviction in their strategies and are also more likely to act in shareholders' best interests, resulting in better performance. Positive Parent companies appear to subscribe to that idea because their managers invest considerably more in the funds they run than Neutral- or Negative-rated firms do. For the average Positive-rated firm, 72% of the firm's mutual fund assets are parked in funds where the managers invest more than $1 million alongside fund shareholders. That percentage drops off to 30% for the average Neutral- or Negative-rated firms.

- source: Morningstar Direct as of 8/31/2012

Additionally, David's observation that funds with higher manager ownership outperform bears true at the firm level as well. Firms where managers invest more than $1 million in 80% to 100% of assets have, on average, 55% of their funds survive and outperform in the five-year period, more than 15 percentage points better than the lowest-investing group.

- source: Morningstar Direct as of 8/31/2012

Bringing It All TogetherWhile each of these criteria can be used on their own to screen or select potential investments, it's much more powerful to use them together. The Parent rating does just that, and the difference in survivorship and outperformance between Positive- and Negative-rated Parents is stark. On average, funds from Positive-rated parents both survived and outperformed 60% of the time in the five-year period compared with a dismal 27% for Negative-rated parents.

- source: Morningstar Direct as of 8/31/2012

The resounding theme is that Positive-rated Parents have more qualities that lead to better performance over time. It's certainly possible to have well-rated fund families with a few lemons, as well as a gem of a fund from a Neutral- or Negative-rated fund shop. However, being mindful of a fund's Parent can help guide you to better stewards of capital and more consistently positive results. To help investors assess the Parents in their own portfolios, in the table below we highlight Parent ratings and related data for the 20 largest mutual fund firms by assets. In future articles we'll dig into those ratings and Parents in more detail.

- source: Morningstar Direct as of 8/31/2012

Director of active fund research Michael Herbst contributed to this article.